When Bond Funds Make Sense

Posted on Sep 3, 2014 11:53am PDT

As you may know, fixed income is integral component to most properly allocated portfolio. In certain cases, it may make up more than half of the portfolios of an investor saving for retirement. As with equities, fixed-income investing offers many different vehicles and strategies. The focus for investors in this space may be fixed on the choice between purchasing individual bonds or bond funds.

Often, investors who choose individual bonds will construct a ladder, or purchase several bonds with varying maturities to create a constant flow of income as these bonds mature. Some investors may choose to forgo this laddering technique in favor of funds, either ETF's or actively managed Mutual Funds, to obtain their fixed income exposure. Still others may choose to combine these strategies in their approach. Determining what fit is right for you can be simplified by examining specific criteria important to you.

Consider whether or not you want to pursue specific asset classes, how much you have to invest, and how likely you are to need to liquidate your investment. Once determined, making the decision to choose bond funds or individual bonds can be less difficult.

Consider Bond Funds When…

You're Looking for Asset Class Exposure.

Bond funds show tremendous advantages in providing investors with exposure to specific asset classes within the fixed-income space. These classes include high-yield bonds, emerging market bonds, foreign bonds, and inflation protected bonds to name a few. In order to dive deeper into fixed-income and specialize in one of these asset classes, one must have considerable skill and expertise in deciding when and where to invest. Pricing can also act as a barrier to the individual investor as larger managers are able to obtain more competitive pricing. As such, it is a good idea to leave this type of investing to professionals with the requisite skill-sets. Smaller bid-ask spreads, and greater expertise make Bond Funds the right move when looking for specific asset classes.

There's Little to Invest.

It is often difficult for investors to create the diversification they seek because there is limited investment capital available. Individual bonds are expensive relative to other investments such as individual equities and ETF's as many price at $10,000 and above. With less than $100-200K to invest in fixed-income, investors are likely not able to effectively diversify a bond portfolio. In this case, investment in Bond Funds may be a more appropriate measure. Bond funds offer low costs and the ability to add smaller dollar increments to each investment over time. This allows investors with smaller dollar amounts allocated to the fixed-income portion of their portfolios to buy into funds that can actively manage bond ladders for them.

There May Soon be Cash Needs.

Liquidity is another advantage to utilizing bond funds. Funds offer increased liquidity to investors compared to individual bonds and may even be cheaper to buy and sell. Selling individual bonds could also drastically reduce overall returns. Bond funds also benefit those investors who periodically rebalance their portfolios by eliminating the need to sell individual securities. Executing trades within mutual funds and ETFs is far easier and more straightforward than liquidating individual bonds that may have large bid-ask spreads. This ease of use is particularly attractive to those investors with smaller dollar amounts to invest in fixed income.